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Navigating the Carried Interest Debate

Jun 04, 2010

Just more than a week ago, the House of Representatives passed a bill that would raise the rate of taxation on carried interest. It's not the first time the House has okayed such a measure. According to ICSC, this is actually the fourth time it's passed the House since 2007. In previous years, however, the idea has died in the Senate. This year, however, the prospect of such a bill getting through the Senate appears more likely.

That's precipitated a flurry of posts and stories in recent days weighing the measure.

Real estate trade groups, including ICSC, are vigorously opposing the change in the tax rate. Jeffrey DeBoer even said the commercial real estate industry was "at war" in reference to the proposed tax.

Meanwhile, Craig Huffman wrote a piece at the Huffington Post from the angle of a small developer that explained why he thinks the lower tax rate is appropriate not just for real estate investors, but for venture capitalists and private equity funds as well.

By investing in troubled neighborhoods, my partners and I reject the notion that these communities are beyond help. Although my firm is still relatively new, we've already used private financing to acquire an office building on the south side of Chicago, and the acquisition has created property maintenance, landscaping and janitorial jobs for moderate and low-income residents of the neighborhood. And this is one of the great benefits of our business strategy: we create jobs every time we acquire a new real estate asset.

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I believe strongly in what I do, but I can think of plenty of general partners who, back in 2006, would have thought twice about starting their firms if they knew that they would be penalized for taking risks and earning profits and building equity in their firms.

I'm not a tax expert, so I'll largely leave the detailed tax analysis to others. However, I will point out that as a risk-taking, entrepreneur, I know firsthand that one of the fundamental principles underlying the tax code is that those who take chances to build businesses and create jobs, including private equity and investment partnerships, should be rewarded with the lower capital gains tax rate when their investments pay off. The revenues all of us receive from our investments are entirely risk-based, with no guarantees, and shouldn't be taxed like a salary.

One of the problems with the debate, however, is that much of the mainstream discussion doesn't take into account the measure's potential effects on real estate. Instead, it's viewed as a punitive tax aimed at venture capital and private equity who are widely seen as abusing a tax loophole. The rate of taxation on carried interest is supposed to serve as an incentive for investors to tie up capital long term and to encourage risk taking. Private equity and venture capital, as I understand the argument, use it as a way of lowering the tax they pay on annual fees and short-term returns. In other words, they are treating what is ostensibly income as an investment gain and thus unfairly paying a lower rate of taxation than they should be. But that's not the way the tax serves the real estate industry where many investors legitimately are investing capital for long stretches.

Nevertheless, even people within the real estate industry aren't sold that the lower rate of taxation makes sense. John Reeder at Marketwi.se argued in favor of the increase.

I just don't see a compelling reason to keep the capital gains treatment there for someone who is earning a fee based on a service, rather than placement of their own money.

To be clear, I would be in favor of lowering the tax rate applied to ordinary income across the board, which would be a fine way in my mind to address this issue (instead of raising the tax for fund managers, lower it for everybody else), so you can't dismiss me as being on the “more taxes, all of the time” side of this debate.

I just happen to think all of the arguments for keeping the carried interest tax at the capital gains rate are really weak. Real estate defenders of carried interest usually say that we should close the loophole for hedge funds, but not for real estate. But that strikes me as silly.

I'm going to assume that the managing partner has a rather large vested capital interest in the venture. I'm also going to assume the managing partner is probably the last to receive his investment back. In exchange for added risk, isn't the investor due a higher ROI? So is the extra 20% on top of his capital gain more capital gain or income? Is it possible to quantify the added risk? I think a hedge fund manager taking his 20% every year sounds more like income, whereas a real estate partnership manager receiving 20% of the appreciation of the investment after holding it for a number of years sounds more like capital gain.

To this supporters of HR 4213 would say, “So what?” If real estate is a good investment, it will be a good investment no matter what the tax rate is. It could be argued that although the returns are less, the portfolio theory behind the allocation to real estate should stay the same, otherwise the portfolio won't be optimized. Essentially, this means that it won't deter people from investing in real estate, so long as their core investing strategies stay the same.

It seems though that much of the debate lacks the context of numbers and that many are ignoring the issue that will change their world more than any carried interest tax ever will.

The national debt of the United States is growing by $5B every day. The carried interest tax, according to the CBO, is estimated to bring in an additional $19B over the next 10 years. See the problem?

I concede that the carried interest tax is a small part of an overall solution, but frankly at this point we're beyond the issue of a carried interest tax. What real estate investors and managers - and other investors alike – should really be concerned about is the debt we've amassed and continue to amass, and the further exacerbation of said debt once the effects of the healthcare bill kick in.

Aside from the Armageddon option, there's only two ways out of debt: growth or taxes. If we don't get growth, we're going to get taxes; in which event investors and fund managers should be less concerned about the effects of any carried interest tax and instead focused on trying to understand the effect taxes will have on consumers and businesses, and how that will affect demand and ultimately asset values.

Frankly, I'm unsure what to make of all of this. The trade associations, understandably, seem to be amping up the rhetoric in talking about what a disaster the tax change would be. I wonder if in practice investors just won't find another way to structure investments to avoid the tax and have their investments treated like capital gains. The argument that seems the most persuasive to me is that the bill should be more fine-tuned. If legislators want to take aim at private equity funds and venture capitalists then the bill should be structured to only affect those industries and should not be a broad restructuring of carried interest taxation. If taxation of real estate investments is being done correctly, it should not be changed.

Have you seen other good posts from commercial real estate insiders discussing the issue? If so, please add any links to the comments section below.